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What advisers need to know about the most complex type of annuity

Variable annuities with guaranteed benefit riders are complicated, and there are some nuances advisers should be aware of

Advisers and insurers alike consider variable annuities with guaranteed benefit riders as the most complex annuity products. Specific characteristics of these annuity contracts can lead to misperceptions among advisers of how the products function, and among clients as to what they're buying.

“A lot of the people selling these products simply don't fully understand it. And why don't they? Because they're so darn complex,” said Jim Shambo, president of Lifetime Planning Concepts. “I've never met a client who understands them, and I've never met a salesmen who fully understands them.”

STICKING POINTS

Variable annuities with guaranteed benefit riders offer consumers an income floor in the event markets perform poorly and allow for upside participation during up markets.

The most popular living benefit rider in VA contracts is a guaranteed lifetime withdrawal benefit (GLWB). In 2014, GLWBs made up just more than 80% of VA sales when a guaranteed living benefit was elected, according to the LIMRA Secure Retirement Institute.

One of the primary areas of confusion for advisers and clients using VAs with guaranteed benefit riders is a “two-bucket” concept, said Mr. Shambo, who is also the former chairman of the American Institute of CPAs' personal financial planning section.

One bucket represents the income base guaranteed by the contract, a 5% annual withdrawal rate for life, for example. The second represents the actual account value, or the underlying principal that is invested.

The account value is the one affected by market gains and losses and contract costs. What investors sometimes don't realize is this account, not the contractually guaranteed income base, is the only one they have access to if they need to liquidate the annuity contract and tap their money.

This could happen in the event of financial stresses such as medical emergency or children needing assistance, or if an investor feels he or she made a mistake in purchasing a contract, and can catch investors off guard if the account value is less than expected, Mr. Shambo said.

Surrender rates for contracts with a guaranteed lifetime benefit are lower than those for other annuity products, according to LIMRA. Rates were 3% for contracts with a GLWB issued before 2013, according to LIMRA's most recent data. For those with a guaranteed minimum income benefit, the second most popular VA rider, it was 3.9%.

Investors continually confuse the features and nuances of the income base versus their account value, which tends to cause the most problems down the road, according to Judson Forner, director of investment marketing at ValMark Securities, an independent broker-dealer.

“The most important distinction you need to make when selling these products is there's a very different relationship for the client between the account value and their income base. Oftentimes clients don't full grasp it or advisers don't fully explain it,” Mr. Forner said.

Flexibility built into these contracts also offers the possibility for client withdrawals in excess of the allowable withdrawal amount. If this occurs, the income base is reduced “in nearly all cases,” and the annual withdrawals would be lower than they were previously, Mr. Forner said.

These provisions are stated up front by insurers, but can be hard to find because prospectuses can be hundreds of pages long, Mr. Shambo said.

COST

The guaranteed living benefit on VAs typically costs around 100 basis points — however, it isn't necessarily charged against the actual account value, but can be against the “reference value” underlying the income-base bucket, explained Scott Witt, owner of Witt Actuarial Services.

For example, an insurer may assess 1% on a $100,000 reference value, but then pull that $1,000 charge from the actual account value of $50,000 (assuming the account had lost value). So the assessed charge in reality would be 200 basis points, or 2%, Mr. Witt said.

Other expenses levied on VA contracts include mortality and expense, administrative and investment charges as well as the cost of the guaranteed benefit, Mr. Witt said. Average cost for an annuity contract and GLWB rider was 232 basis points in 2013, according to LIMRA.

“Advisers and consumers need to look at the aggregate impact of all of these [costs],” Mr. Witt said.

“If you want to broaden the tent of the annuity business, then you need to improve the simplification of these products [for advisers],” Bill Lowe, president of Sammons Retirement Solutions, said. More straightforward riders would help, he added.

For example, some contracts have age-rollback provisions in which investors exercising a guaranteed income rider at age 70 would receive an income stream as if they were, say, five years younger, thereby reducing the income stream, said Greg Olsen, partner at Lenox Advisors Inc.

“Try to have a client remember that's the situation,” said Mr. Olsen, who added he's a proponent of VAs when priced fairly and positioned correctly.

VAs with living benefits are so complex due to what insurers have to do under the hood — sophisticated hedging and risk management strategies — to offer the associated contract guarantees, said John Kennedy, head of retirement solutions distribution for Lincoln Financial Distributors.

However, some think clients should be better informed about some of the contract nuances.

“I think that realistically the client should know exactly what they're buying when they buy it,” Mr. Forner said. It's most important for advisers to explain the “boundaries” of a particular product — for example, explaining any excess-withdrawal parameters — so clients know what they can and can't do in the future.

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